Clarient, Inc. (CLRT)

Q2 2008 Earnings Call Transcript

August 6, 2008 5:00 pm ET

Executives

Don Markley – IR, Lippert/Heilshorn & Associates

Ron Andrews – CEO

Mike Pellini – President and COO

Ray Land – SVP & CFO

Analysts

Debjit Chattopadhyay – Boenning & Scattergood

Raymond Myers – Emerging Growth

Joy McCall [ph] – Centaur Capital Partners [ph]

Lee Alper [ph] – Hammock Investors

Keith Bergner [ph] – Hatfeld [ph]

Michael Sabuski [ph]

Presentation

Operator

Welcome to the Clarient 2008 second quarter results conference call. At this time, all participants are in a listen-only mode. Following management’s prepared remarks, we will hold a Q&A session. (Operator instructions) As a reminder, this conference is being recorded, August 6, 2008.

I would now like to turn the conference over to Don Markley. Please go ahead, sir.

Don Markley

Thank you. This is Don Markley with Lippert Heilshorn & Associates. Thank you for participating in today's call. Earlier today, Clarient issued news releases announcing financial results for the quarter ended June 30, 2008 and the completion of validation studies for the Clarient DX prostate profile. If you have not received these news releases or if you'd like to be added to the company's distribution list, please call Lippert Heilshorn in Los Angeles at 310-691-7100 and ask for Amy Higgins.

Before we begin, I would like to remind you that management will make statements during this call that include forward-looking statements within the meaning of federal securities laws. These statements involve material risks and uncertainties that could cause actual results or events to be materially different from those anticipated. For a list and description of those risks and uncertainties, please see the company's filings with the Securities and Exchange Commission. Clarient disclaims any intention or obligation to update or revise any financial projections or forward-looking statements, whether as a result of new information, future events, or otherwise. Furthermore, this conference call contains time-sensitive information and is accurate only as of the date of the live broadcast, August 6, 2008. I will now turn to the call over to Ron Andrews. Ron?

Ron Andrews

Thanks, good afternoon, everyone, and thank you for joining us. Welcome to Clarient's second quarter 2008 conference call. As Don Said, I'm Ron Andrews, Clarient's CEO. With me today is our new CFO, Ray Land, and our President and COO, Mike Pellini.

Second quarter 2008 was another solid quarter of revenue growth for Clarient. The 71% year-over-year growth achieved in the second quarter was primarily due to our increasing volumes in all service lines and the continued transition of our service mix towards leukemia and lymphoma testing, which, again, grew significantly. Our ability to consistently grow our volumes each quarter is a solid indication that our business model and value proposition are continuing to gain even greater momentum in the market. We now posted 16 quarters of sequential growth, and are very pleased with our ability to maintain solid gross margins in light of the increasing volumes added to our operation. This is indicative of our ability to absorb the strong growth without significant expansion in our current infrastructure, as well as the improvement in our revenue mix towards the higher margin lymphoma/leukemia testing.

In early July, Congress voted to extend the fee schedule that affords us an increase in reimbursement in some of our fastest growing service lines. This extension should allow us to maintain our current gross margin levels, while we add some much needed infrastructure and staff to maintain the industry-leading service levels our customers have become accustomed to from Clarient.

In the quarter, we were able to take advantage of our increasing operating leverage to absorb the significant cost of our billing system transition and severance cost. The total incremental expense associated with those items was over $1.2 million; and despite these incremental events, we were still able to post our second consecutive quarter of positive adjusted EBITDA.

Before I turn the call over to Mike to take us through the operating metrics for the second quarter, I'd like to take a second and welcome Ray Land, our new CFO. Ray joined us in June and brings significant experience in both the genomic space and in public company financial reporting. His background will serve us well as we strengthen our internal controls and Sarbanes-Oxley compliance. Once Mike takes us through the operational metrics, Ray will walk everyone through the second quarter financials and I'll finish with an update on our exciting Insight DX program. I'll now turn the call over to Mike. Mike?

Mike Pellini

Thanks Ronny. As you heard, we saw significant growth during the first half of 2008 and the operations team delivered a solid performance, maintaining strong efficiencies and in turn, consistent gross margins. Clarient is now among the leaders in revenue per FTE, which is an important industry accepted ratio in laboratory efficiency. The combination of clear departmental metrics, further economies of scale, and a committed team of professionals who believe in the Clarient brand all work together to drive our margins, our extremely high standard of patient care, and our customer satisfaction. Servicing our clients and our patients remains our highest priority.

So now let us turn to the operating numbers. Our leukemia/ lymphoma testing volume grew at an impressive 86% year over year. Our breast prognostic and solid tumor testing volumes grew 30% year over year. And our molecular testing increased 98% versus the second quarter 2007. In Q2 2008, we handled over 26,000 patient cases, which was a 50% increase over the second quarter of 2007 and a 9% increase over the first quarter of 2008. Total testing volume grew 60% in the quarter when compared to the second quarter of 2007 and 10% versus the first quarter of 2008. This continued volume growth was catalyzed by the acquisition of 53 new customers in the quarter, seven of which came from our A target list.

Now let me take a moment to comment on some of the efficiency metrics we routinely track in the lab. First, the number of sessions per FTE per month remained at approximately 600, which is more than 60% above Q2 2007's number. Second, the number of slides stained per FTE per month was over 2,800 versus 2,100 in Q2 2007. And third, the number of lab tests run per FTE per month was approximately 500, which is consistent with the first quarter of this year. As I stated in last quarter's call, we did not track this metric last year, so I don't have a year-over-year comparison. Finally, as our volumes continue to expand, our corrective actions per acquisition remained well below the industry average at significantly less than 1%.

As we move through the second half of 2008, we expect to maintain our gross margins in the high 50s while we also embark on some important capital improvements. These efforts include the commencement of an information technology project for better inventory control and tracking, as well as the start of an effort to prepare the LIS infrastructure for continued revenue growth. Further, with only relatively minor alterations to the current floor plan, our facility still has room for another 30% volume expansion. And we have access to an additional 20,000 square feet, which will allow us to double our capacity at this location.

Thus far, we believe an important part of the company's success has been attributable to partnerships developed with leading academic institutions and clinicians, who worked with us to remain at the forefront of anatomic pathology. Going forward, we will look to further these strategic relationships by building our network with world-class research and clinical facilities.

In addition, we are considering adding to our footprint with the establishment of an East Coast facility, which will broaden our menu offering and build on the impressive growth, which we are seeing in that part of the country. We believe such enhancements to our current operations are in the best interest of our clients, our patients, and our shareholders. These results provide us with solid momentum as we progress through 2008. We are rapidly achieving critical mass operationally and the commitment among our employees has never been stronger. I'd now like to turn the call over to Ray to highlight our financial progress in the quarter.

Ray Land

Thanks Mike. Before I start the financials, I'd like to comment on why I decided to join the Clarient team. First, having been at Safeguard, I was familiar with and impressed by the quality, integrity, and especially the energy of the management team that Ron has put together and the culture they have created. Second, the company has a very powerful growth strategy in place. And finally, I recognize that the underlying dynamics of the healthcare industry in general and cancer treatment specifically have created a tremendous market opportunity for Clarient. These factors cause me to believe the company is positioned to create significant value. And I look forward to being part of the team that takes Clarient to the next level.

Now I would like to turn to our financial highlights for the second quarter as reported today in our earnings press release. Our total revenue of $16.9 million increased by 71% over the second quarter of 2007; driven by a favorable revenue mix, increased volume, and higher Medicare reimbursement rates. Our gross margin in the quarter increased to 59% compared to 44% in 2006, driven by the growth in volumes, the increased reimbursement rates, and higher employee productivity. Total selling, general, and administrative expenses increased approximately $4.6 million or 65% to $11.8 million, driven by increased bad debt expense, billing costs, severance costs, and professional fees, as well as increased investment in sales and marketing and our information management infrastructure.

There were a number of expense items in the second quarter that we do not expect to reoccur this year, including the severance costs, the incremental professional fees related to audit issues, and billing conversion costs. We are also being very proactive in seeking ways to reduce our legal and auditing fees, including seeking fixed fee quotes for certain legal work and the hiring of an internal auditor. In addition, towards the beginning of the fourth quarter, we expect our billing costs to decline as we migrate towards one system. Further, we believe that our bad debt expense will decline as a percent of receivables as we increase the timeliness of our billings. However, we will continue to invest in our sales, marketing, and information system infrastructures. Even with the increased operating expenses, we were able to reduce our operating loss for the quarter by $1 million as compared to the second quarter of 2007.

Our net loss from the quarter was $4.3 million or $0.06 per share compared to a net loss of $3.2 million or $0.05 per share for the comparable quarter in 2007. The increase in our net loss was driven by a $2.1 million increase in interest expense due to borrowings under Safeguard’s new mezzanine financing facility. During the quarter, we amortized and marked to market warrant costs of $1.9 million associated with the issuance of that debt.

We announced yesterday that we were able to complete a new $8 million senior secured credit facility with Gemino Healthcare Finance. On July 31, 2008, we drew down $5 million and used the proceeds to reduce the outstanding debt on the Safeguard mezzanine financing, which had a higher interest rate. This should reduce our future interest costs.

For the quarter, the company's adjusted EBITDA was again positive at $200,000, which brings our six-month total adjusted EBITDA to $1.2 million. Adjusted EBITDA is defined in our press release. At June 30, 2008, the company's cash balances were $2.1 million compared to $1.5 million at December 31, 2007. Our available cash on hand plus additional availability from the Safeguard mezzanine facility totaled approximately $10.7 million as of quarter-end. As of the end of July 2008, we have $13.5 million available under that facility. Our days sales outstanding were 77 days in the second quarter of 2008 compared to 84 days in the comparable quarter in 2007 due to improved cash collections in the quarter.

Before giving guidance, I'd like to emphasize that our focus is on generating long-term value to Clarient shareholders by delivering strong annual revenue growth and achieving operating profitability with vigilance and focusing on those activities that add value to our company. Consistent with this long-term view, we intend to provide only annual financial guidance, which we will update each quarter. As discussed in our press release, we are raising revenue guidance for the year from a growth range of 30% to 40% to a range of 45% to 55%. This results in a dollar range of $62 million to $67 million. The two main reasons for the change are better-than-expected year-over-year increase in volume and the recent extension of the Medicare price increases by Congress. We will update this guidance again at the end of the third quarter.

In closing, I expect that we will have a busy fall season meeting with new and existing investors. And I look forward to meeting many of you in the coming months. Now back to Ronny.

Ron Andrews

Thanks Ray. I'd like to take a few minutes to provide an update on the progress in the Clarient Insight DX program. The Clarient Insight DX breast profile remains on schedule as we prepare for a launch in the second of 2008. While we've had some unexpected challenges in getting enough samples with the appropriate demographics and outcome data, we did locate such a cohort in the second quarter and now are in the process of completing assessing on over 400 samples with known outcomes. This data combined with our original data set should provide the basis for our validation of the Clarient Insight DX Breast Profile, which we will release at the upcoming College of American Pathology meeting in late September. We continue to focus on collaborating with the community of pathologists. And consistent with our mission, our plan for the launch of this exciting test is to make the service available to our current and prospective pathology clients during the fall.

We will use this time to acquaint pathologists with the markers used in the profile, as well as how to utilize the information provided in our rich recurrent scoring process to augment the information they currently have at their disposal to assist oncologists in fully understanding a patient's treatment options. We plan to launch the test to the oncology market at the San Antonio Breast Conference held in December. As we've consistently stated, we want to have a methodical launch where we incorporate the pathologists into the process to ensure the most accurate use of the information provided with our test. Identifying the most appropriate cells to analyze for genomic and proteomic tests is essential to the most accurate results. And the only way to ensure the correct cells are captured for analysis is when they are chosen by a pathologist. We continue to believe that the Clarient Insight DX Breast Profile will add significant value to the role pathologists play in helping breast cancer patients receive the most appropriate therapy and look forward to finalizing our data sets and launching this exciting test.

It's very important to understand that Clarient is one of the leading send-out laboratories for breast cancer diagnostics in the U.S. as we will manage well over 30,000 cases in 2008. We believe over 70% of these cases will be candidates for our new test, representing a large, captive market of over $50 million for our tests once we launched. While the revenue ramp towards attaining our share of that captive market would be staged over the next several quarters, we believe our launch process will generate sustainable momentum for our test over time. Needless to say, we're eager to get our profile to market so we can speak more about our study results and our comparative data to other like service offerings, as well as begin to see the revenue impact on our rapidly-growing base business.

Also in the second quarter, we were able to conclude the final round of clinical validation data for our prostate gene's license from Health Discovery last fall. Through the first three phases of the clinical validation process, the initial clinical results consistently revealed the gene's sensibility to differentiate between cancer and non-cancerous tissue. Through the first three phases of clinical validation, we have a sensitivity of 90% and a specificity of 97%, both very good indications of the gene profile's ability to identify grade 3 cancers and above. We believe these results are very impressive and when compared to the current screening test, PSA, our specificity and sensitivity are significantly greater. The strong improvement in these key factors could allow us a solid position as an adjunct to the current screening modality to help men with prostate cancer get a more accurate diagnosis sooner and minimize the need for unnecessary biopsies. Our next steps for the Clarient Insight DX Prostate Profile are to complete our internal documentation and expand our study to include urine sample types. Obviously gaining the ability to utilize the profile in urine could add significant value to men over age 50 given the lack of specificity of the current screening test. We will also begin the technical marketing component of our commercial launch and start the process of presenting our data at upcoming meetings and conferences with the goal of initiating the missionary process to educate the marketplace about the potential utility of this exciting test.

At ASCO in early June, there were a number of papers presented highlighting the importance of a marker called K-ras in determining the therapeutic course for certain types of colon cancer. In response to the emerging need for this information, in late June, we announced the launch of a Clarient's K-ras test to complement our colon cancer program offering. From the early response, it's apparent that the market is responding favorably to Clarient's version of this new, important molecular test. K-ras is a great example of how Clarient's ability to extract minute amounts of messenger RNA from small samples via micro-dissection, which differentiates our services from those of other lab offerings of this test, we've already encountered competitive scenarios that other competing labs need more tissue and longer lead times to complete the analysis versus our industry-leading five- to seven-day turnaround time from a single tissue slide. In the first month since our launch, we've already hit a run rate of over 50 samples per week, which translates into an annual incremental run rate of over $1.5 million. From inception, our goal was to create a company that was uniquely positioned to translate the emerging molecular diagnostic discoveries into successful diagnostic information to advance the personalization of cancer management. The K-ras opportunity is an example of the types of diagnostic tests we aim to develop and provide and we look forward to launching more emerging diagnostic and prognostic tests as the market need presents itself. All in all, we remain very encouraged with the early return from our Insight DX program and will continue to update you on our progress as we move into the third quarter.

As we end our prepared remarks, I'd like to summarize management's thoughts regarding our 2008 performance to date and highlight key milestones for Q3. Given the positive vote to extend the current Medicare fee schedule and our consistent ability to grow our volumes in the first half of 2008, as Ray stated, we've decided to increase our 2008 revenue guidance from a 30% to 40% growth rate over 2007 to a growth rate of 45% to 55% over 2007. We have reached a point in our growth; we're seeing solid traction on the bottom line. And with the transition costs of our new billing system now behind us, we believe we'll be able to continue to reduce our operating losses as we capitalize on our momentum in revenue growth, gross margin improvement, expense management, and our new billing process.

Assuming we continue to see incremental operating leverage, we will need to make some investments throughout the year in our financial infrastructure and in the clinical process for our Insight DX program, as well as hire additional sales staff to support the launch of our Clarient Insight DX Breast Profile in the fall. These investments are in our 2008 plan and we believe this can be accomplished without significant impact on our progress towards our financial goals.

Some of the key goals for Q3 are as follows – we want to continue to achieve at least 25 new customer acquisitions, maintain greater than 95% retention of our current customer base, and continue to expand our same-store sales with our current customer base, which currently stands at around 30%. We also want to successfully launch the Clarient Insight DX profile to the pathology community at the College of American Pathology meeting, as well as continue our current momentum with our K-ras test launch. And finally, we want to begin the trials of urine samples and initiate the technical marketing phase of commercial launch for our Insight DX Prostate Profile.

This concludes our prepared comments and I'd now like to open the call for questions.

Question-and-Answer Session

Operator

(Operator instructions). Your first question comes from the line of Debjit Chattopadhy with Boenning & Scattergood.

Debjit Chattopadhyay – Boenning & Scattergood

Good afternoon, gentlemen.

Ron Andrews

Good afternoon.

Debjit Chattopadhyay – Boenning & Scattergood

First question regarding the expense line, now should we – there was $1.2 million in one-time charges roughly in the quarter. Now should we – for the third quarter assume that you will have – your expense will be more in the $10.5 million to $11 million range? Or do you think there will be an incremental increase in the expense considering your plans for marketing the Insight DX tests?

Ray Land

Yes, this is Ray. Nice to meet you. We expect going forward that SG&A to be around 62% of revenue for the rest of the year. So going into the third quarter, the expenses that we talked about in the press release, which was the increased billing costs, severance costs, increased professional fees, and some bad debt expense, we don't – we do not expect them to reoccur in the third quarter.

Debjit Chattopadhyay – Boenning & Scattergood

No, my question was really, I mean, clearly that won't reoccur. But considering that you have a new marketing initiative for the Insight DX tests, so will the expense hold at around $11.7 million or do we actually see an incremental decrease going forward? So if you say it's 62%, so that's a decrease from 69%.

Ron Andrews

Yes, Debjit, let me just answer the question about the marketing activities. Obviously we are going to be ramping up our marketing activities of both the breast profile as well as the prostate profile. But we don't expect to see significant increases in the marketing and sales expense in the third quarter. However, we are going to be interviewing and hiring some new sales and marketing folks, but we should – that impact would probably be most likely in fourth quarter. And once we get a better handle on what that looks like we will certainly be able to give you a better answer as to what the impact might be. But clearly we're not expecting that to be a significant impact in Q3.

Debjit Chattopadhyay – Boenning & Scattergood

Okay. And the other question with regard to the interest expense, it came in at about $2.5 million. What is the magnitude expected for the third quarter? And the share count; is there any dilution in terms of warrants to safeguard (inaudible) in the third quarter?

Ray Land

Well, we're not going to give guidance by quarter as I mentioned. We're going to give annual guidance. But I will comment that we took out the Gemino financing and we paid down about $5 million of that Safeguard mezzanine financing, which was a 13% interest rate. And the Gemino financing is about 7.7%. So you will see a decrease as a result of that lower interest rate.

Debjit Chattopadhyay – Boenning & Scattergood

Okay. And the third quarter is traditionally the strongest quarter for Clarient. Now do you see the same trends this year?

Ron Andrews

Debjit, you know, right now, obviously we're too early in the quarter to really give any insight to that other than to say that we don't expect to see any significant issues in terms of revenue growth, anything that would inhibit revenue growth for the quarter from our historical periods. So based on that, I'd say that everything is on track for the third quarter based on what we see here today.

Debjit Chattopadhyay – Boenning & Scattergood

One last question, a dip in gross margins compared to the first quarter, you had come in at about 62%, right now it's at 58% or 59%. Any specific reasons for this?

Ron Andrews

Yes, I'm going to let Mike answer that because he's got some of the detail around that. Mike?

Mike Pellini

Yes, Debjit, I think in general our focus on the gross margins has really been to move it to the high 50s. I think even as we talked about at the end of the first quarter, despite the fact that it was over 60% for that quarter, I believe we were consistent in saying that our targets are within the high 50s, which is – we believe is strong gross margin for our industry. So rather than comment on any specifics, our guidance is consistent in the high 50s. Occasionally if it hits 60%, we're not going to complain.

Ron Andrews

Yeah, Debjit, as we've spoken before I think our real balancing act is to make sure that we have the appropriate level of personnel and equipment in our lab to maintain the service levels that we really have provided in the past that has differentiated Clarient from the other labs in our industry. And obviously if we squeeze down the cost of sales too tight, we run the risk of creating gaps in our service lines and service that we deliver to these customers. And obviously we want to be careful about that because in this business, as you well know, there's very little long-term contracts. So we don't want to lose a customer. And that's why our retention rates are such an important component of the metrics that we talk about. And as you know, and year to date we've got over 97% retention rate of current customers. And we believe part of the reason that they stay with us because of our ability to continue to serve them in the way we have. So we have to balance that. That's why we're saying our gross margins, where they are today, is probably a good indication of where they're going to stay. As our volumes grow, we want to make sure that we're hiring people at the right time so that we don't overburden any one area of our laboratory.

Debjit Chattopadhyay – Boenning & Scattergood

Yes, thank you very much. And I'll get back in the queue.

Ron Andrews

Great. Thanks Debjit.

Operator

(Operator Instructions). Your next question comes from the line of Raymond Myers with Emerging Growth.

Raymond Myers – Emerging Growth

Thanks for taking the questions and congratulations on the top-line growth.

Ron Andrews

Hey Ray. How are you?

Raymond Myers – Emerging Growth

Doing great. And a warm welcome to Ray Land. Welcome.

Ray Land

Thank you.

Raymond Myers – Emerging Growth

My first question is regarding the lymphoma/leukemia tests. Last quarter I believe it was, or this quarter perhaps, we've launched the HemeScan product from CombiMatrix. And perhaps I missed it, but did we review what – how the launch of that is going?

Ron Andrews

We did not specifically talk about that, Ray, but let me give you a high level overview. Back in – and when we launched that test, the real goal of that test was to create two things – one, a better cost profile for a component of a type of leukemia called CLL, a test called cytogenetics that has traditionally been a loss leader in our industry. And obviously the HemeScan test was a test that allows us to move clients away from a test like cytogenetics that where we lose money to a test that is A, we believe scientifically superior, and B, also allows us to change the cost profile of that test in our operation. So we did finish our validation in second quarter. We did go to a full market launch in second quarter. And we are now in the – what we believe is going to be a fairly lengthy missionary phase of sales and marketing effort to really convince commissions. And you know this as well as anyone, that the inertia to do nothing in this space at times can be a very strong force. And so our role right now is to put the missionary work out there, to begin to move physicians away from traditional cytogenetics towards using the HemeScan product. We have been running clinical tests. I don't have the number right in front of me exactly what we ran for the quarter, but we are seeing that test gain some traction and we'll look forward to reporting on that as we see better traction and have better granularity into the numbers.

Raymond Myers – Emerging Growth

Well, that's great. Help me understand, Ronny, of your K-ras tests, you're up to 50 samples a week after a month. Why is that such a faster ramp than the cytogenetics switch to the –

Ron Andrews

That's a great question. And I think it's a good message for everyone to really understand about our business. In June at ASCO, there were a number of papers presented by pharmaceutical companies highlighting the importance of K-ras in determining patients that will or will not respond to a very popular drug called Erbitux. And so what we have done is we have capitalized on an emerging market opportunity for personalized medicine and therapeutic direction. And so, when we see opportunities like that, one of the things we've always talked about with you and other analysts is our goal is to be in a position as a company to move very quickly and execute a launch of a test where it becomes medically necessarily. So it really, the difference between the HemeScan and the ASCO is just the leverage you get – I'm sorry, in the K-ras is the leverage you get when a test is really promoted by a pharmaceutical company.

Raymond Myers – Emerging Growth

It was interesting that the analyst reaction to ImClone's presentation that you need to be K-ras wild type to benefit from their drug was generally that ImClone's drug wouldn't be – Erbitux wouldn't be used much for prostate cancer. That was the reaction that I had heard from the ImClone analysts. Are you finding that a lot of doctors are ordering this test for the purposes of prescribing Erbitux in colon cancer?

Ron Andrews

We are seeing that. I mean, our early returns from our field force is that this is a growing dynamic and that this message is getting out. In fact, there are a couple of other, you know, academic as well as pharmaceutical industry groups that are preparing to present data and we suspect that K-ras will get further press in coming quarters. And so it looks like that the K-ras opportunity is going to increase. When we put our press release out, you'll notice that we limited our total available market numbers just to the use of K-ras for colon cancer. But clearly the K-ras pathway is something that can be utilized in many other solid tumors. And so it'll be interesting to see how this data plays out. But clearly we're seeing a tremendous amount of interest in the marketplace in K-ras today. And our – week over week, our volumes are growing pretty significantly. And so it'll be interesting to see over the course of third quarter how this actually ramps up.

Raymond Myers – Emerging Growth

And then – that's encouraging. I want to switch over and ask Ray some questions about the billing system. Now you're new, Ray, right? You're brand new to the company?

Ray Land

I'm brand new to the company, yes.

Raymond Myers – Emerging Growth

What's your background in billing and collections?

Ray Land

Well, I ran a billing system in – well, my background is I was with Coopers & Lybrand. I was with Genencor International for seven years, took them public, and they got purchased in 2005. I ran a billing system in – when I was with Campbell's Soup as one of the reportees to the CFO. But I haven't run a billing system in a healthcare company.

Raymond Myers – Emerging Growth

Okay. It is early to expect you to understand laboratory billing, all of its ins and outs this quickly, but can you give us any perspective so far? Or – what are you seeing here? And how do things look? I mean, I think investors are very interested in getting cash out of your receivables and paying down your debt. So are you going to be able to help us to do that?

Ray Land

Yes. I – what I see is this transition to the Zysen [ph] system and I have met with them and spent considerable amount of time with their controller and a considerable amount of time understanding the system. It is going to be a significant improvement in not only the processing part, but also I believe that it is going to have a direct impact on the timeliness of the billings as compared to the third party system we had, which I think is going to improve the collectability of the billings. So it's the first month, June was the month that we installed it. So it remains to be seen, but based on what I've seen so far, I think it is a vast improvement over our past system and I believe it, again, is going to have a direct impact on our reduction of bad debt expense.

Ron Andrews

Hey, Ray, one thing I'd like to comment on, you know, when we contemplated going to our own in-house billing system, really it is predicated on the fact that we were growing so fast that companies our size really need to control their own billing. I mean, clearly we had a farm out that we were using as an outside billing agency that was doing a fine job as we were a smaller company, but as we grew, we clearly outpaced their ability to in a timely fashion get our bills out. And so the reality is that bringing it in-house, A, gives us more control over the process, B, gives us more control over collections and how we go after the patient bill component of any billable event, and certainly, we believe that having more access to data, more granularity to data, which the Zysen system will also give us in terms of management reporting tools, that those three things alone will really help us stay on top of this and do a better job at collections. And as Ray says, over time minimizes the bad debt exposure.

Ray Land

Yes. And in addition, as a CFO, one of the first things I looked at was what is the cost of the new billing system versus the cost of the old system. And on an annualized basis, I estimate the savings to be about $2 million a year.

Raymond Myers – Emerging Growth

That's great. Now what – I think Ronny just hit it on the head right there, the cost of bad debt. As you switch over from the old system to the new system, are you – have you done an analysis yet and are you finding – so it's a two-part question – any unusual or bad – other bad debt that you believe you may have to recognize by year-end?

Ray Land

Not by year-end. We did a scrubbing during the month of June, looked very closely and we added additional $500,000 to our allowance for bad debt. And I think most debt is attributable to the time limits of the billings and the aging. So I think we scrubbed them clean and I do not expect a significant increase going forward.

Raymond Myers – Emerging Growth

Okay, well, that's very encouraging. Oftentimes when there's a new CFO, they'll scrub the books and write things down. You – so are you saying that you've basically done that and are confident that you're not going to be writing things down?

Ray Land

Yes, I didn't do it as part of being the new CFO. It was done as part of the transition to the new billing system and going through in great detail the aging of the receivables and making sure that going forward we don't have something in there that's not uncollectible. And that resulted in an incremental charge of about $500,000.

Raymond Myers – Emerging Growth

And that was expensed during the second quarter?

Ray Land

Yes, it was.

Raymond Myers – Emerging Growth

Okay, great. Well, to the extent that it's not recurring, that will help your results going forward.

Ray Land

Yes, we do not expect it to be recurring.

Raymond Myers – Emerging Growth

Okay. Well, that's great and I'll be calling you, Ronny, to follow up. Thank you very much. And good job on the continued top-line growth.

Ron Andrews

Hey, thanks Ray.

Operator

Your next question comes from the line of Joy McCall [ph] with Centaur [ph].

Joy McCall – Centaur Capital Partners

Good afternoon. Thanks for taking my questions. I'm just interested, I know in the past when you've given the metrics out for test volumes, you've reported it sequentially and this quarter I think you reported it year over year. Is that correct in terms of the specific breast versus PCR and so forth?

Ron Andrews

It is, but I think, Mike, we have the – do we have the quarter-over-quarter volumes as well?

Mike Pellini

We do have the quarter-over-quarter volumes. And I think for at least part of them, I reported on those. Just to be consistent, let me pull up the actual numbers again so I don't misstate anything. So if you look at quarter over quarter from Q2 versus Q1, our solid tumor testing, which does include breast testing, increased 4%; our leukemia/ lymphoma testing increased 14%; and then our molecular which includes both the PCR and some other testing, increased by 20% quarter over quarter.

Joy McCall – Centaur Capital Partners

Okay. Great. Thank you. And then just touching on something you mentioned in your prepared comments regarding expanding same-store sales, you mentioned a 30% number I think and I wasn't sure exactly what that was, 30% over what?

Ron Andrews

Yes, Joy, sorry about that. That – the – we have been talking in the past about the importance of same-store sales and we committed that this quarter we would give some insight as to what we had in terms of number of customers who actually order more than one service from us. And that did increase. It's now at 30%, so 30% of our customer base is ordering more than one service from us. And obviously we believe that's a good news story because we've had this growth and we continue to grow quarter over quarter and year over year in a fairly significant manner. And we still have a lot of same-store sales opportunity before us, as well as many new custom opportunities to acquire. So, again, as we've talked in the past, our three-legged stool for growth continues to be new customer acquisition, new same-store sales, and then now the addition of these new proprietary market capabilities. And so we're on track in all three areas to continue to balance our revenue growth over those three areas.

Joy McCall – Centaur Capital Partners

Okay. And then can you just give me a comparison number, either from the previous quarter, how many were ordering more than one service or from the previous year?

Ron Andrews

I can give you the previous year. The previous year was less than 5%.

Joy McCall – Centaur Capital Partners

Oh, wow, okay. So that's a substantial increase, okay. Great. Okay, that's great. And are – is it sort of any one area where you're able to move from – let's say, from breast to other solid tumors or from leukemia to PCR, is there any sort of pattern that you're seeing?

Ron Andrews

Yes, Joy, I don't have that level of granularity, but just my intuition tells me that it's breast customers that are moving to leukemia/lymphoma with us. And in obviously we market into the oncology space through our pathology partners. So part of our ramp up in our leukemia/lymphoma business is really enabling our community pathology customers to be able to compete with the likes of Genoptics and Genzyme and people like that because we don't directly go into the oncology space very frequently. Typically we go in, empower the local pathologists with all of the advanced tools we can provide them, and we encourage them to go into their local community oncology areas and advance their business. And we get the pull-through business from leukemia/lymphoma. And so that's what we're seeing in our same-store sales arena. And, again, I don't have exact numbers on that, but that's certainly my intuition. And I believe that will hold up when we have the facts to talk about.

Joy McCall – Centaur Capital Partners

Okay, great. And then regarding the prostate cancer tests, which you put out a press release today, can I just clarify, is this a different test than the one that was – is supposed to sort of differentiate between sort of gray area Gleason scores?

Ron Andrews

This is the same gene profile and this is the phased approach in terms of launching it. Our first goal of this test was to really take advantage of what we believe the first indication could be, which is the least path of resistance to market. And that is to identify the significant – or today there's over 600,000 biopsies a year where there's PSA-positive/biopsy-negative patients that need further workups. And what this test will do, as it – as we sit here today, we have the data to support the ability to provide very – well, we think very powerful information to treating clinicians to understand that 25% of those 600,000 biopsies that will not need to go on and get a secondary or a tertiary biopsy. Obviously once we get revenue coming in the door from this indication, the goal will be to really enter more advanced clinical studies and trials to identify and see if this gene set could have the same capability to differentiate between Gleason 7 that would go on to aggressive disease and those that don't. But today, at least for the foreseeable future, the whole goal of the program today is really get the program to – or the product to market as a – with the indication of PSA-positive/biopsy-negative and be able to rule out those biopsy-negatives that don't need further assessment.

Joy McCall – Centaur Capital Partners

Okay, great. Thanks for that clarification.

Ron Andrews

Sure, Joy. Thanks for the questions.

Operator

Your next question comes from the line of Lee Alper [ph] with Hammock Investors.

Lee Alper – Hammock Investors

Yes, just wondering, now that you've been working with CombiMatrix for about six months and you started the program, are you looking at maybe taking on any more of their tests?

Ron Andrews

That's a good question. I mean certainly we are very favorable with Combi and we like their technology. And as more capabilities or need for their capability in the marketplace arises, we'll certainly look at their gene expression platform as a future platform for us to utilize for the combination of information necessary to really draw therapeutic decisions. Mike, do you want to comment further on –

Mike Pellini

Well, I would just say we meet with CombiMatrix twice a month. And they certainly keep us abreast of their additional clinical indications. So as additional indications emerge, which are consistent with our market, we will certainly bring them online. But certainly we anticipate – I think growing our offering with them over the coming quarters.

Lee Alper – Hammock Investors

Okay, fine, thank you.

Ron Andrews

Thank you.

Operator

Your next question comes from the line of Keith Bergner [ph] with Hatfeld [ph].

Keith Bergner – Hatfeld

Hello?

Ron Andrews

Hello, Keith, good afternoon.

Keith Bergner – Hatfeld

Hey, congratulations on a great quarter.

Ron Andrews

Thanks Keith.

Keith Bergner – Hatfeld

I've got a few questions here. And perhaps you've already answered them or you can expand on them a little bit. But you talked about the breast cancer growth at 30%, another cancer testing at expansion rates of 80% to 98%. I understand that if you haven't done much of those type tests, it's easy to achieve a very high expansion rate. But my real question is, is that –you talk about the facility that you have now with a 30% possible volume expansion. At what point do you become saturated there with the facility that you have and have to go out and look for additional facilities? Or – and another question I've got is about the East Coast expansion.

Mike Pellini

Keith, this is Mike. That's a great question and I'll clarify. The 30% expansion comes with actually very little in terms of capital improvements. We simply – we had additional lap space planned. We can break down a wall or two and expand into some adjacent facilities. So it's actually a very small step for us to continue to grow our business by another third. In addition, we reside in an approximately 75,000-square foot facility. We have access to another 20,000 square feet here in the building. And once we expand into the – should we decide to expand into the rest of the facility, we can actually double our capacity. So for the foreseeable future, we do not feel that we need an additional facility here in Aliso Viejo. As I mentioned, we are looking at additional opportunities nationally, which may – which might in fact have an impact on our local needs.

Keith Bergner – Hatfeld

Okay. Well, as a follow-up to that then, you're referring to this potential East Coast facility. How much are you budgeting for the cost of this new facility? And how is it going to be paid for? Obviously it's going to take a lot of money to put this facility into operation. Is SFE going to come forward and allow for the expansion? Or are you going to do it through additional stock offerings? Or is it going to be all done through revenues? Where's the money going to come from and how are we going to get to breakeven on this new facility?

Ron Andrews

That's a good question. And let me start by saying this – obviously we've contemplated all of these moves within the financial plan that the company has in place. And we – as I said earlier, our goal is to balance investments like these expansions with the need to hit operating profit, et cetera. And so as we do that, Keith, there are plans for us to continue to grow the company as well on the top line, but also get to use the leverage we've got on the bottom line to achieve profitability while we're still growing. There are ways to partner. There are ways to move on the East Coast without necessarily expending as much capital as you might think. And Mike's got some ideas about what those expenses might look like, so, Mike, why don't you share with Keith your thoughts on this?

Mike Pellini

Well, as always, and certainly we've been doing this carefully over the past year. We will continue to monitor our CapEx and all of our COGS very carefully. We are actually in the process where we are entering into our strategic planning process for the second half of the year, so we'll focus on year-end 2008 and 2009. And at this point, I think what we'll do is we wanted to give you an indication of some of the things that we were thinking about. And we can update you with specifics on the next earnings call. But we think we have some opportunities that we'll look at in the coming quarters.

Ron Andrews

But, I mean, just to be candid, Keith, you mentioned SFE and just to be transparent, our goal is not to continue to utilize Safeguard as a bank. I mean, their incremental borrowing rate is prohibitive for us as a company. And obviously one of the things that we did with the Gemino financing was make our first step in our cap structuring process to really get us to a point where we have access to funds at a much lower incremental borrowing rate that can allow us expansion and still allow us from an interest expense perspective to meet our bottom line goals of operating profit and ultimately net profit.

Keith Bergner – Hatfeld

Okay. And that's – that was one of my other questions. When you – when somebody mentioned about the recent borrowings, the $5 million of the $8 million credit line, and it was used to pay down the debt with SFE, and they said – and you kind of got to watch for how people describe things or how they say things, but it said it should allow for a reduction in interest expense. It doesn't seem – it seems to me like that's kind of black or white. Is it going to be a reduction in interest rate or is it not? And if it really should be a reduction in interest rate, what would transpire to cause it not to be a reduction?

Ray Land

No, it is a reduction, yes.

Ron Andrews

It's a reduction, Keith.

Keith Bergner – Hatfeld

All right, good. All right. And let's see here. How about expansion, is there any possibility or is there any forethought on looking at possibly buying out any other labs or something like that to expand in that fashion?

Ron Andrews

Well, certainly as a management team, we always look for ways to improve shareholder value. And I've said consistently over the last few quarterly calls that if an opportunity came up where we could accretively bring on an East Coast facility that would bring, you know, accretive value immediately to all shareholders, we would entertain that, especially in light of the success of our prostate profile. It's very possible that there might be a lab out there that has a urology focus that would give us an immediate impact in terms of touching a urology base. But today, we don't – we haven't seen an opportunity like that that would be immediately accretive that we believe would benefit our shareholders. But clearly we'll keep our eyes open. If something like that came up, Keith, we'd certainly – we'd entertain it.

Keith Bergner – Hatfeld

And then I think my final question here is regarding Safeguard. They seem to be – and I know that you guys have to be – you can't answer for them, but you seem – you certainly are aware of what's going on with their relationship with you. They seem to be more than a hold mode as to expanding as they were in the past. And I'm sure that has a lot to do with the economics of this time. But in view of your possible needs to expand or whatever, I'm not sure that Safeguard is going to be able to be able to step in as they have in the past and come forward or come forth like they have. And is that a problem for you or do you foresee that being a problem? Or what do you think of the Safeguard position with relationship to Clarient? I mean, is Safeguard contemplating or do you know of whether or not they're contemplating selling off or reducing their exposure to Clarient?

Keith Bergner – Hatfeld

Well, Keith, I – you'd have to talk with Safeguard about that. But let me answer the first part of your question because I think it is important. Safeguard has been a very strong supporter of Clarient through the years. And obviously Clarient would not be where we are today had it not been for the long-term vision and support of Safeguard. So let me say that first. I think it is important to note, though, that Safeguard's business model is not to incubate companies to the $100 million mark. And clearly as Clarient continues to grow, our own independent Board is really adamant about creating a situation where we stand independent of Safeguard from a standpoint of needing cash from Safeguard. And the idea is not to have to continue to use Safeguard as a bank, but yet let them become an investor only and move – now that we've got a balance sheet that's strengthening and obviously the revenue growth and the leverage we have at the bottom line, we're in a much stronger position today to find more traditional means for financing the company than to keep going back to Safeguard at the incremental borrowing rate that we see from Safeguard today. So that is not a criticism of Safeguard. It's just a fact that they're a venture capital fund and they candidly want to see those type of returns on any investment they make, including money they earmark to potentially allow Clarient to borrow. So going forward, our goal is to become more independent from a access-to-capital perspective from Safeguard. And that really is regardless of Safeguard's intentions with Clarient.

Keith Bergner – Hatfeld

Okay. One final question – again, with the loss that we had this quarter of $0.06 per share, and I know that we – that Clarient is a growth company and that isn't going to allow for much profitability to the bottom line or to the shareholders, but – and I know the question has been asked before and answered, but when do we ever foresee the company really at a net-net breakeven and/or making money?

Ron Andrews

Well, I think first off I think if you look at the investments we made in second quarter, those were timed investments that we knew we needed to make to support an infrastructure that really allows this company to move towards the $100 million revenue mark. And clearly we couldn't continue to grow at the rate we were growing without the investments we made in second quarter, which did impact in an incremental fashion our operating expenses. However, if the company continues to grow, you can draw the growth trajectory out. And if we minimize those one-time expenses over the coming quarters, I think it is easy to see that from an operating profit perspective, we're on the right trajectory to achieve what you're looking for. I think that the second part of your question really becomes – it becomes important to look at just the interest expense that we're paying and we will continue to pay. And really, that's going to – the only way to get to net profit is really to completely recap and restructure the cap structure of the company. And that's something that management is looking at. But obviously we want to do that in a market that's favorable to terms that we believe we can – we should be able to attain today given the strength of our business.

Keith Bergner – Hatfeld

Okay. I have some more questions, but I think I'm monopolizing it, so I'll let you guys go. You guys are doing fantastic. Keep it up. Let's keep the company growing.

Ron Andrews

Thanks Keith.

Keith Bergner – Hatfeld

Thanks.

Operator

Your next question comes from the line of Michael Sabuski [ph], who is a stockholder.

Michael Sabuski

Hi. Nice to speak to you. We've spoken on the phone before. I'm going to ask a question about Health Discovery, the ally, let us call it that, with the technology. Now apparently that's what the prostate cancer survey or whatever you want to call it, that's the test that you're hopeful you – shows hopeful signs for the company. Am I correct about that?

Ron Andrews

That's correct. It's just the test that we licensed from Health Discovery, yes, a year ago. And they have continued to be extremely supportive, along with Dr. Fritchie [ph] from MD Anderson, in terms of getting us the clinical samples we need to do the work and validate our own internal processes, as well as put together the study outcomes that you see reported today in our earnings release.

Michael Sabuski

Well, I haven't had a chance – I saw the headline and that's what sort of pushed me to speak about it. But I really haven't had the chance to read it. So perhaps you can highlight it just a little bit, if you have any additional news from the prior testing that they had done.

Ron Andrews

Sure. If you want me to give you a summary, I mean, to date there's been over 322 prostate tissues tested in three cohorts, a phase I, a phase II, and a phase III cohort. Clarient was responsible for the phase III component, but MD Anderson and HDC collaborated on the first two phases. So combined, there was over 322 tissues tested. I might comment that that is more samples than one of our competitors used to exceed FDA clearance for their breast cancer genomic test, so we think that's clearly a number of samples to sustain the validation data that we've got, which was a sensitivity of 90% for correctly identifying the presence of grade 3 or higher prostate cancers, and a specificity of 97% for correctly identifying non-cancer cells. Those would be normal and BPA samples. So I think overall, the validation studies have rendered a test that could be very powerful in the marketplace in augmenting what today is a very poor screening specificity. As we know, PSA has a specificity of way less than 50%. And so clearly with a 97% specificity, we feel like that going forward that this test has a good value in terms of its ability to augment data that will help clinicians make a more appropriate decision about who should and who should not get a follow-up biopsy.

Michael Sabuski

Oh, and so that's really pretty good news. Do you expect that there will be follow-ups on this particular test? Or is there – is Health Discovery going to come up with more? Because it seems like they are expanding their own little shop as well. And so does it appear that there are going to be more cooperation with Health Discovery?

Ron Andrews

Well, we do hope so. I mean, obviously Health Discovery has a pipeline of tests that they are working on. The only one that Clarient obviously has the rights to today is this prostate gene profile. However, our goal would be to do an excellent job with the commercialization of this product for them such that they would want Clarient to be their go-to facility for anything else that came out of their pipeline. But you'd have to talk to them about that. That's not something that I can really comment on further than that.

Michael Sabuski

Well, maybe I will. Anyway, I was very pleased with what the team, yourself, are doing with the company. It seems like you're really making great strides. Keep it up.

Ron Andrews

Thank you, Michael.

Operator

There are no further questions. I would like to turn the call over to Ron Andrews for any further comments or any closing remarks.

Ron Andrews

Well, first off, I would like to thank everyone. This has been fairly lengthy call, but we had a lot of information to cover today, so I appreciate your patience with us. As always, I'd like to take the chance to thank our employees. We have an extremely dedicated staff of people, both in the field and internally that work very hard every day to fulfill our mission of taking cancer personally. And so I'd also like to thank our shareholders for your continued support. We believe obviously that we'll well on our way to achieving the opportunities and the goals that we set out for the company four years ago when we arrived. And we look forward to fulfilling some of the vision that we have, as well as updating you on the progress of our Insight DX program and other areas as we go through third quarter. Thanks for your time today.

Operator

Ladies and gentlemen, that concludes your conference call for today. We thank you for your participation and ask that you please disconnect your line.

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